Investing in Cryptocurrencies as Securities: An Interview from a Legal Perspective

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Digital currency practices have exploded in recent months, bringing to the forefront new regulations. This means VC investors looking to get a piece of the action need to do further due-diligence and remain informed on the legal side.

According to Inside Bitcoins, last year two Bitcoin and blockchain-related startups raised over $1 billion in total investment. This is a massive increase from the $347 million invested in the space in 2014.

So what are the latest issues around cryptocurrencies? How will the recent SEC announcement impact investors? Bob Graham, partner and head of the digital currency services practice at Friedman LLP, has been receiving inquiries from both Bitcoin and blockchain-related firms and investor funds asking for audits and advice.

Graham tells Bitcoin Magazine in an exclusive interview what VC investors should be aware of and how Bitfinex recently engaged Friedman to assist with an audit.

What issues are VCs facing related to digital currency?

There are several issues that VCs are facing when making investment decisions. Comparability of financial information between companies and industry trends are important factors that many investors use. There are a lot of startups in the digital currency industry, but some entities are becoming more mature and sophisticated, which brings more sophisticated investors.

Which accounting rules apply?

Currently under U.S. GAAP [generally accepted accounting procedure] rules, there are no specific accounting principles to address digital currencies, and therefore companies must interpret existing standards to determine which standard best applies by analogy to the transactions they are accounting for. This can result in divergence in practice and incomparability of financial information for investors looking to make an investment decision.

Another issue that many investors are facing is the lack of regulation and clarity. On the regulatory side this week we saw the SEC announce it would regulate the DAO. What is your view?

The SEC released their “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO,” which provided some clarification, in that the Commission determined that DAO Tokens are securities under the Securities Act of 1933. I have discussed this conclusion with members of the digital currency community, and the general consensus was that it was anticipated that the SEC would include tokens as considered securities under the Securities Act of 1933.

The SEC concluded that whether or not a particular transaction involves the offer and sale of a security will depend on the facts and circumstances, including the economic realities of the transaction. This is important, as the SEC is evaluating tokens on a case-by-case basis using the fact pattern outlined in the Report of Investigation into the DAO.

They provided some key considerations that companies and their consultants can evaluate in determining if tokens being offered would be considered a security under Securities Act of 1933.

There has been a significant influx of capital into digital currency companies during 2017 through token offerings, which vary significantly in structure. Some of the members of the community fear that regulation may slow innovation, but there is a delicate balance [between] innovation and investor protection. Some more sophisticated investors, including VCs, have been hesitant to enter the token-offering environment due to the lack of regulation.

We hear the phrase “Wild West” quite a lot when people refer to the cryptocurrency world. Could you expand on why you think a “Wild West” type scenario is being created?

One could say that the lack of regulation, relatively short timeframes and significant amount of capital being raised through token offerings could create a “Wild West” scenario when compared to a traditional route of an initial public offering. Companies looking to perform a token offering have to evaluate the structure of their offering and utilize lawyers and accounting firms that have experience in this industry in order to ensure they are appropriately protecting the investors, employees of the companies and the company itself.

With the SEC report discussed above, the SEC has put companies in this industry on notice that they are expected to follow the registration process with the Commission and take appropriate steps to comply with U.S. federal securities laws unless they are subject to exemption. It will be interesting to see how quickly the SEC proceeds in evaluating other token offerings that have been completed and any future token offerings; but they will be a key part of bringing regulation to the industry, which will hopefully improve investor confidence and allow digital currencies to become more mainstream investment vehicles.

Can you tell us more about the theft and compromised-exchanges issue facing the space? How could those types of issues have been avoided? Will the environment become safer?

I think that the environment will become safer as the digital currency markets continue to mature … The U.S. Department of Justice unsealed an indictment imposing a $110 million fine on the Bitcoin exchange BTC-e for violating anti-money laundering laws. This is important as BTC-e is not domiciled in the U.S., and shows that U.S. regulators are willing to pursue action across borders. There is also an ongoing IRS investigation of the digital currency exchange Coinbase, which is domiciled in San Francisco, regarding tax reporting for digital currency transactions and customer records.

As exchanges continue to mature and subject themselves to additional checks and balances, whether through an audit of the financial information or an audit of their internal controls and processes, they will continue to develop better systems and processes which will hopefully promote a safer environment. These exchanges will continue to be the targets of theft due to the considerable value of their customer accounts and the digital nature of the transactions, but with continued development and more defined and tested processes the potential for loss will hopefully be reduced.

Keep in mind that no matter how sound an environment there is, there will always be a possibility of theft or other targeted attacks, but that isn’t something unique to the digital currency industry as it occurs often in other industries as well.

What role has Friedman LLP played in helping Bitfinex following the recent theft of more than $65 million worth of bitcoins from its exchange?

Unfortunately, I can’t go into a lot of detail about client accounts outside of what is public knowledge regarding the press release. I can say that as far as we are aware, there [are] many exchanges that are currently audited and I think it is great that Bitfinex is taking the time and effort to engage an auditor and open their books and records to external examination in order to encourage investor and customer confidence.